We already know remaining mechanical is key to good trading. We understand we need to manage winners and take advantage of high implied volatility when we get it. What we have not done is quantify how managing winners impacts the number of winning trades. Here we take a look at how managing winners increases our percentage of profitable trades and also, how varying levels of IV impact our P/L as well.
Letting a short strangle expire worthless sounds appealing. Who wouldn’t want to keep all the premium collected? However, we know leaving a trade on until expiration not only does not help us, it actually puts us at risk.
From 2005 - 2015, we looked at over 2500 instances of selling a one standard deviation strangle in SPY with 45 days until expiration (DTE). We compared the results of holding until expiration versus closing the trades at 50% of max profit. This time we also looked at how management helped turn losing trades into winners.
On the slide below, the red dots illustrate losses avoided by managing trades at 50%. These trades, had they run until expiration, would have resulted in losses. We increased the number of profitable trades from 82% to 90% by actively managing winners.
We also looked at how controlling order entry, with respect to implied volatility (IV), affects our trades. Selling into higher IV allows us to collect more premium. When we collect a greater credit, our probabilities increase as do the size of our profits. Specifically, when we can sell into a period where IV is above 20% we see a noticeable increase in our P/L.
To be fair, higher IV tends to yield a higher return, but it can also lead to larger losses. That should make sense as high IV often translates into larger moves in price. In our study, the largest losses took place in 2008 and 2011. Neither managing winners nor the existence of high IV helped reduce exposure to tail risk.
Managing trades at 50% is what allows us to take winners off the table before they become losers. It is the difference between the blackjack player who walks away after a short period of time with a small profit versus the player who amasses a large profit, sticks around, gives it all back and then some.
Higher IV increases our P/L further because it increases the premium we collect. It is like knowing the card count in blackjack and betting into a favorable count. We cannot avoid tail risk and there are times no matter how mechanical we are, trades go against us. It is trading’s trade-off, so to speak. We are okay with that. We just want to increase the odds in our favor as much as possible.
Josh Fabian has been trading futures and derivatives for more than 25 years.
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